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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is founder and president of MacroPolicy Perspectives
Higher for longer has become the mantra in bond markets this year. Mostly it echoes central bankers’ strategy in tackling high inflation — raise short-term interest rates high enough and keep them there long enough that they cool economic activity and bring inflation back down to target.
Factors other than monetary policy are also often cited in explaining why inflation and interest rates may remain higher this cycle. They include higher government budget deficits around the world and fragmentation in global supply chains as rising geopolitical tensions alter trading relationships creating a higher underlying run rate on inflation.
These factors are only the dark side of the story: The surge in longer-term bond yields that started this past summer came first and foremost as the US economy proved more resilient than expected while inflation cooled notably faster than anticipated. This was in direct contradiction to the macro narrative that a recession would be required to bring inflation down.
This outcome stems from the reappearance of the holy grail of economics — productivity gains. Productivity facilitates economic growth without inflation since you are combining resources in ever more efficient ways. It can also be associated with higher equilibrium interest rates, since the economy does not rely on low interest rates to grow and thrive.
Economists generally assume a growth trend in the US around 2 per cent that embeds an assumption that productivity will grow at about 1.5 per cent a year and population growth will be in the neighbourhood of 0.5 per cent. In the year to September 30, non-farm business sector productivity grew 2.2 per cent after an abysmal performance the year before, twice the 10-year trend before the pandemic of just 1.1 per cent per year.
Some of the bounce-back can be traced to recovering global supply chain operations. Pandemic-related frictions were a major source of sand in the gears of business operations in 2021 and 2022 and inflation in consumer and industrial goods prices. This year has seen a rapid normalisation in supply chain operations and an attendant cooling in goods inflation. This source of productivity improvement could be shortlived, since recovering supply chains won’t continue to lower unit production costs.
The real question is whether productivity can continue to grow at a healthy pace. There are two reasons to think the productivity performance could improve on the lacklustre performance following the financial crisis of 2008-9.
The first has to do with the sizzling hot labour market recovery. Record amounts of people quit their jobs in the past few years. This was a challenge for companies but quit rates have come back down toward pre-pandemic levels which can provide a near-term boost to productivity as the costs of hiring and training new workers comes down.
The churn of workers in recent years could also pay longer term dividends as it may mean that workers are matched up with employers who are a better fit. In a recent poll from the Conference Board, 62.3 per cent of US workers said they were satisfied with their jobs in 2022 — up from 60.2 per cent in 2021 and the highest level recorded since the survey began in 1987.
Another byproduct of a hot labour market — as well as the unique operational challenges of the pandemic — is that we had the first recession without an extended fall in business investment, a hallmark of most downturns.
Businesses kept investing in equipment and intellectual property at a historically high rate to meet the needs of remote work, as well as offset some of the need for workers amid a very tight labour market.
The technological tools companies have at their disposal to re-engineer business processes and realise efficiencies have arguably never been more abundant. If they realise anything close to a historical average return on investments made over the past few years, we may very well be in for a better productivity trend this cycle.
The proof will be in the pudding as to whether inflation can continue to cool without pronounced economic weakness. If we are not on an improved productivity trend then rates may not stay higher for longer. Central bankers would be forced to bring inflation down the hard way through a recession which would likely drive longer-term interest rates back down at the expense of risky asset prices.
The current constellation of higher longer-term rates and higher housing and equity prices effectively banks on a better productivity trend, and there are at least a few reasons for some optimism.